Professional Documents
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firms legal owners (that is, its shareholders). Thus the goal of the firm is to maximize shareholder wealth by maximizing the price of the existing common stock.
time frame over which profits are to be measured. Would this mean short-term profit, or long-term profit?
It is easy to manipulate the profits through various
accounting policies.
Profit maximization goal ignores risk and timing of
cash flows.
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Cash flow is what matters Money has a time value Risk requires a reward Market prices are generally right Conflicts of interest cause agency problems
while it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.
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possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.
Cash flow, and not profits, drive the value of a
business.
We must determine incremental cash flows when
cash flows if the project is selected, versus what they will be, if the project is not selected.
2011 Pearson Prentice Hall. All rights reserved.
expect to be compensated with additional reward or return. Investors expect to be compensated for delaying consumption and taking on risk.
Thus investors expect a return when they put their
savings in a bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk)
(such as stocks and bonds) at any instant in time fully reflect all available information. Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa. Note there are inefficiencies in the market that may distort the prices.
ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers)
her own set of values, which forms the basis for personal judgments about what is the right thing.
Sound ethical standards are important for
business and personal success. Unethical decisions can destroy shareholder wealth (ex. Enron Scandal)All rights 2011 Pearson Prentice Hall.
reserved.
finance:
1) Where to Invest? (Capital budgeting decision) 2) How to raise money to fund the investment? (Capital structure decision) 3) How to manage cash flows from daily operations? (Working capital decision)
uncertainty Prentice Hall. All rights tools help adjust for 2011 Pearson financial reserved. time and risk.
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Sole Proprietorship
Partnership
Corporation
Hybrid
S-Type
LLC
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Sole Proprietorship
Business owned by an individual Owner maintains title to assets and profits
Unlimited liability
Termination occurs on owners death or by
owners choice
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Partnerships
Two or more persons come together as co-owners
General Partnership: All partners are fully
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have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm. 2011 Pearson Prentice Hall. All rights
reserved.
Corporation
Legally functions separate and apart from its owners
Corporation can sue, be sued, purchase, sell, and own
property
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of the corporation, oftentimes through elected board of directors. Shareholders liability is restricted to amount of investment in company Life of corporation does not depend on the owners corporation continues to exist through easy transfer of ownership 2011 Pearson Prentice Hall. All rights Taxed separately reserved.
ownership, Easier to raise capital, Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies)
Drawbacks: No secrecy of information,
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WRMAS
economy. Financial markets help facilitate the transfer of funds from saving surplus units to saving deficit units i.e. transfer money from those who have the money to those who need it.
See Figure 2-1 for three ways to transfer capital in the
economy:
Direct transfer Indirect transfer using the investment banker Indirect transfer using a financial intermediary
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Figure 2-1
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Offering Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities.
and sold to a limited number of investors.
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one year). Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases.
2011 Pearson Prentice Hall. All rights reserved.
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